13 comments:

No, but they are buying up a major share of medium to long-term Treasuries. If you were to focus on the 7-15 year range, the Fed's share would be much higher. BTW, "all" is a strawman. The Fed has guidelines that limit purchases to a maximum of 35% to 40% of the amount outstanding of any security. In my opinion, that is still a large share.

First, some observers do claim the Fed has been buying up all or close to all of the debt and is enabling the large budget deficits. This figure puts those claims to rest.

Second, the entire yield curve is compressed. So even if one does look at certain maturities it still doesn't explain low interest rates across the entire term structure. (Nor does it explain why interest rates on safe assets across the globe are depressed.)

Third, even though the Fed is moving out on the yield curve so is the U.S. Treasury. The effect, then, is almost a wash (and yes, it undermines the efficacy of the QE2, Operation Twist as I discussed here).

I couldn't find data on 7-15 years specifically, but based on data from the Fed's SOMA holdings and the figures in the Treasury's quarterly report, the Fed's note and bond holdings add up to about $1.6 trillion out of a total of about $9.5 trillion total. Thus, the Fed is holding 20% of these longer maturities. So we are still left with 80% of treasury notes and bonds having been bought by other parties. Again, this is remarkable given the huge run up in public debt. The demand for safe assets appears to remain unsatiated.

You make a fair point about interest rates around the world. Nominal two-year yields in Switzerland dropped to around -50 bps last summer (I haven't looked in a while).

But I don't know what part of the yield curve is not under the Fed's influence. They are rapidly buying long-term debt, they control short-term rates, and they promise to keep rates low for a few more years. Some research has suggested that changing the supply of longer-term debt can impact the earlier part of the yield curve.

A great source of information is Stone & McCarthy, but a subscription is required.

Benjamin, I always admire your enthusiasm. You are right that there is an almost insatiable demand for the monetary base, but I doubt it would be there if the public thought the expansion of the monetary base were expected to be permanent. A permanent increase of that size implies a higher future price level. But a higher expected price level would cause demand for the monetary base to fall today. Buying up all the debt would be a clear signal that there would be a huge, permanent expansion.

Now, Woodford's critique is that the past QEs have not been very effective because the expansion is only believed to be temporary. A NGDP level target is a way to effectively get the public to believe some part (not all!) of the expansion is permanent. So there is a middle ground here.

Sorry I confused you with anonymous. Alas, I don't have access to Stone & McCarthy. Would love to read what they have to say.

To be clear, I am not saying the Fed has no influence over long-term rates. Only that the decline in the 10-year from just over 5% to about 1.5% today cannot be explained by Fed purchases alone. The studies I have seen puts the estimate at about 1% of the roughly 3.5% decline.

I looked at the Zero Hedge post and it said it the Fed holds 27% of 10-year equivalents. That still means 73% is being held outside the Fed despite the large run up in the debt. These other holders are enabling the large deficit more than the Fed.

Regarding the Fed's influence on interest rates more generally, I take the view that there is a natural interest rate--one driven by the fundamentals of the economy (see link above)--from which the Fed can only temporarily cause actually interest rates to temporarily deviate. For example, if the public began to believe there would soon be much higher inflation and/or higher real growth interest rates would start to increase across the yield curve in anticipation. The Fed would have to respond to this development--its a follower. And right now I see the Fed long-term interest rate forecasts as just that, they are reflecting the weak state of the economy more than signalling monetary stimulus.

Now the Fed can still push rates below their natural rate level. I believe the Fed did so in the early-to-mid 2000s during the housing boom. It is just that now I see the opposite problem, market interest rates have been above the natural rate.

Regarding the Zero Hedge piece, it's significant that the Fed's share of duration is growing at more than 10% a year, with no signs of stopping. The Fed seems to be soaking up duration almost as fast as the Treasury can create it. To me, it seems like the Fed is steamrolling the market.

By analogy, suppose there were 100 million cars in the country and 10 million more are made every year. Every year, the government buys 9 million (old or slightly used) cars from people. One day they stop buying. Wouldn't this have a severe impact on the auto industry and the car market?

I agree with the idea of natural interest rates. Do you have a view on where the 10- and 30-year rates would be absent the Fed?

I will dig deeper into the Fed's SOMA activities and will be happy to share what I can.

Thanks for engaging me. Here are my latest thoughts on this after further pondering Zero Hedge's post and your comments.

Yes, the 10% accumulation rate would add up fast and the Fed's influence would be significant and distortionary. But, here is the rub. If the public truly believed the Fed's holdings were going to get that large in the future and that the holdings would be permanent (i.e. a permanent increase in the monetary base), then we should see today a big surge in inflation expectations (and possibly real growth expectation) that would be reflected in rising treasury yields. In other words, the approximately 85% of treasuries still held outside the Fed should be be seeing big interest rate and price changes today (before the Fed owns a majority of treasuries) if the Zero Hedge scenario were expected to come true.

This may sound strange, but to some extent I wish markets did take the Zero Hedge scenario more seriously. If they did, they would automatically start diversifying their portfolios away from safe, liquid assets toward riskier, higher yield ones. To the extent there really is lots of slack in the economy and the risk premium is artificially elevated, this massive portfolio rebalancing would kickstart a robust recovery. And the Fed would not have had to purchase all that many bonds after all. The market would have done the heavy lifting. So maybe I should be promoting Bill Gross and Zero Hedge's work:)

I can't give you exact numbers, but based on the seemingly insatiable demand for safe assets across the globe, I feel fairly confident that the natural interest rate level of long rates is unusually low.

I should note that in my view there are actually two natural interest rates. A long-term one based on long-term growth and saving trends of an economy, and a short-term one based on business cycle developments. My sense is that the short-term natural rate is really low now while the long-term version has not changed all that much.

Something I have been thinking about a lot lately is researching a way to come up with a real time estimate of natural interest rates. There have been attempts to do so using calibrated theoretical models as well as the use of market data. There has to be some hybrid attempt and hopefully soon I can start working on how to estimate it.

This post is setting up a rather unfair choice, bordering on a false dichotomy.

You say you are addressing those who say the Fed is responsible for the ENTIRE decline in interest rates, and that because the Fed doesn't own ALL treasuries, and because the Fed isn't responsible for ALL drivers of interest rates, that you conclude "don't blame the Fed!"

But wait a minute, what about those (like me) who argue that while the Fed isn't solely responsible for the declining interest rates at any given time (Fed plus market), that they are nevertheless solely responsible for a real world downward pressure on existing interest rates, which is manifested by a downward shift in nominal interest rates from their "natural" rates?

More importantly, why do you believe it is necessary for the Fed to own a particular sized portion of the treasury market before they can be "blamed" for declining interest rates? That thesis breaks down as soon as one realizes that the Fed merely has to communicate a promise to buy treasuries at historically "unconventional" rates, before non-Fed owners of debt have an incentive to raise the exchange prices of government treasuries (and thus lower the yields).

It can be argued that a higher valued "front run the Fed" premium or a "Bernanke put" premium has been added to treasury prices in the world market.

Thus, the Fed doesn't need to actually own X% of all treasuries before they can be identified as primarily responsible for the declining yields.

Imagine tomorrow the Fed announced, and the announcement was viewed as credible, that the Fed will no longer engage in QE, no longer engage in any "unconventional" monetary policy, and will simply maintain the existing "percent of the total treasury market" portfolio of treasuries. Do you think the yields on treasuries will remain the same, go up, or go down? I would expect the yields to go up, and substantially, because the "front run the Fed" or "Bernanke put" premium value would collapse.

Now, you may insist that while the rates may rise, they won't rise back up to pre-2006 levels, because you argue that there has since been a real world decline in "natural interest rates", due to the financial collapse, recession, etc.

Notwithstanding the fact that it can be argued the Fed caused those events to transpire, in which case the thesis the Fed "isn't to blame" for the declining interest rates doubly breaks down, I would much rather focus on your invoking of the IS-LM analysis to explain why interest rates have declined.

While you say the IS-LM analysis is "far from perfect", you nevertheless went ahead and used it anyway, because it can provide a justification for why interest rates have been declining.

You did not mention this, but the IS-LM is not only "far from perfect", it is internally contradictory. The declining marginal efficiency of capital doctrine, which is a core component of the IS-LM analysis, contradicts the very context under which the IS-LM analysis was originally advanced, which was a justification to "refute" the argument that falling wage rates and prices can achieve full employment.

The use of the declining marginal efficiency of capital doctrine allowed its users to claim that a fall in wage rates and prices cannot achieve full employment, precisely by ignoring the context of a fall in wages rates and prices and rise in employment, and switching to a different, in fact opposite context, which could only exist if wage rates, production costs, and prices rose instead of fell. For the IS-LM analysis assumes a rise in the prices of capital assets, no fall in production costs, but constant, or even rising costs of production, and no increase in the supply of labor relative to capital, but rather an increase in the supply of capital relative to labor.

This flaw connects back to interest rates, our subject at hand, by way of what actually happens to profits coming out of a depression. The IS-LM analysis predicts falling profits as more net investment is made, but if we maintain the context of falling production costs, then profits will actually rise, almost dollar for dollar, with the rise in net investment.

The IS-LM literally just refuses to accept falling wage rates and prices, and believes falling "demand" (which by the way is treated as real demand and nominal demand interchangeably) will keep workers permanently out of work and capital goods permanently idle.

Yes, the 10% accumulation rate would add up fast and the Fed's influence would be significant and distortionary. But, here is the rub. If the public truly believed the Fed's holdings were going to get that large in the future and that the holdings would be permanent (i.e. a permanent increase in the monetary base), then we should see today a big surge in inflation expectations (and possibly real growth expectation) that would be reflected in rising treasury yields.

This isn't necessarily true. You are ignoring potential (and currently transpiring) deflation in the shadow banking system that can work side by side the increase in the monetary base, which won't significantly increase price inflation, but will still significantly increase the "distortions".

Plus, there is also a "front run the Fed" or "Bernanke put" premium in treasuries that obliterate traditional models of determinants of treasury interest rates. Treasuries don't have to yield the rate of inflation at minimum. Investors in 30 year government bonds for example could be willing to pay a very high premium, and accept below inflation yields, if they expected the Fed to step in and stop yields from rising if they ever did rise. This doesn't require the Fed to actually own those 30 year bonds. It just needs a credible commitment that they will.

Your chart shows that a lot of debt was created in 2008. But no new universities were built or bridges nor were pensions funded. Nobody new got a free medical education or something society could use.If there were the same number of buyers of debt in 2006 as 2009 who were equally rich...well there obviously were not. There is obviously a lot more dollars out there chasing safe assets.This chart shows me that there was a huge inflation of the money supply given to a couple rich banks who would never want to lend that out to , yuck, people.So, obviously again, the model of looking to the Fed to ease unemployment is foolish. The Fed just puts us in so much hock we can never service the hock. What job did all that hock create?Maybe more importantly, what could possibly stop the Fed from making all that hock once again? They apparently like doing that; bankers like it and bankers are their friends.(I realize I "just don't understand". But this is I think still a democracy and it would help if people could clearly understand what the powerful players in our system are doing and NOBODY I know has a clue.)

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I am an assistant professor of economics at Western Kentucky University in Bowling Green, Kentucky. I am using this blog as an outlet to express my ideas, concerns, and questions on macroeconomics and markets.